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Chinese Shares Up but Repercussions of Crash Unclear

Chinese shares were up around six per cent on Thursday, July 9, after record volatility earlier this week sent markets plunging, creating widespread investor panic. Since June 12, the Shanghai Composite Index has lost approximately 30% of its value, while the smaller Shenzhen Composite, which has more tech companies, is down more than 40% over the same period.

Why did this happen?

The Chinese stock market had been displaying signs of a bubble, growing at a rate of 120% so far this year. Investors poured money into Chinese stocks with the belief that the government was fully in control, and the stock market wouldn’t fail, in spite of weak economic growth and company profits. Chinese retail investors – in large part, inexperienced “mom and pop” investors, which made up about 80% of the market – drove the market up, many using borrowed funds to increase their exposure. Leveraged investing was heavily restricted until 2010, when Chinese authorities gradually began loosening the regulations. This unstable, over-leveraged environment, in combination with share prices outpacing growth and company profits, resulted in a dramatic overvaluation of the stock market.

China is now trying to control the crisis by suspending initial public offerings, easing rules on margin loans to investors and giving money to brokerages to buy stocks. On June 27, the People’s Bank of China cut its benchmark interest rate to a record low, and lowered the amount of required reserves for certain banks. At the same time, almost half of the listed companies have pulled their shares off the market –something that wouldn’t be allowed under securities regulation in North America. The government’s moves so far have had little impact. On the positive side, China has a strong banking system and many additional policy tools at its disposal.

What could this mean for the global economy?

We can expect more volatility going forward as the battle between government-led support and negative sentiment, especially towards small and mid-cap stocks not benefitting from this support, continues. Offshore Chinese equities’ lower valuation and leverage will likely provide some downside protection. Although the International Monetary Fund left its latest growth expectation for China unchanged at 6.8% this year, of greater concern outside China is the possibility of a global economic slowdown, and the uncertainty of the overall impact of a fluctuating stock market.

What could this mean for your portfolio?

While volatility is a major issue in China, the onshore equity market is still relatively closed to foreign investors, who own just 1.5% of the market, so your portfolio should not be directly affected. MD has limited exposure to primarily offshore Chinese stocks, however this exposure is embedded within the broader global mandate – a diversified approach that has helped us mitigate the risk. We are confident that our emerging market managers are uniquely positioned to navigate through this difficult market environment. For example, during the month of June, PIM Emerging Market Pool not only had an underweight position to China versus its benchmark, but it also added value by selecting stocks that outperformed the broader Chinese equity universe. We encourage you to speak with your MD Advisor if you have any questions about your portfolio. Your MD Advisor can work with you to ensure your portfolio is diversified and well positioned to withstand market volatility.

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